EU ministers apparently made little progress last week on terms under which the European Stability Mechanism (ESM) would recapitalize weak banks, though they still hope for an agreement by end month. That said, if a draft plan circulated by European Commission Secretariat is a guide, we are seeing another step in the disappointing (and risky) retreat from last year’s promise to decisively break the link between troubled periphery banks and their sovereign. This plan looks like more of a bruise, or a slight bend, rather than a break. The good news is that events likely will force a change down the road.
One notable element of the document, which reports on features agreed by Euro ministers, is to make a country whose bank was receiving aid put in its own resources alongside the ESM. If a bank is to receive direct support, the country in question must first ensure that the bank’s capital meets the minimum level of 4.5 percent for tier 1 capital, and then must pay in 10 to 20 percent of the amount of the recapitalization. This looks steep. Such burden sharing is justified by the need for the country to address all legacy problems (the ESM only resolving a capital shortfall that occurs once the ECB takes over supervision), but moral hazard concerns look also to be in play.
Other ways in which the ESM plan will fail to address the debt sustainability question were already known–banks need to be systemically important and pose a threat to eurozone stability, as well as solvent with the injection of capital; the country needs to be able to issue in markets but at risk of fiscal unsustainability if it fully funds the rescue; and creditors and private shareholders of the bank receiving support will need to have paid up (affirming the precedent set in Cyprus). The recap program is limited to 50 to 70 billion euros from the 500 billion euro fund. As pointed out by the FT, its unclear that many of the banks at the center of the crisis (Anglo-Irish, Bankia and Laiki for example) would have qualified for assistance under this scheme.
It is not surprising that policymakers would be wary of announcing more ambitious plans while the German constitutional court is considering the legality of ECB support policies, and ahead of German elections. But what if German elections come and go, and the policy doesn’t change? The best that can be said is that, when faced by the risk of imminent crisis, creditor governments have done the minimum each time to avoid a country collapse. Markets remain untroubled, apparently anchored by its confidence that Europe has shown the flexibility to change in the past, and would do so again. Two problems with that: first, that diminishing popular support for European policies and the rise of non-traditional political parties may make justification of changes harder in the future than it would be now; and of course, having to go to the edge of the cliff to get the policy changed has a corrosive effect on markets. It’s hard to see how this helps.
This piece is cross-posted from Macro and Markets with permission.